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Thursday, March 26, 2009

Keynes once famously wrote that “Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.”

A recent article in Prospect Magazine argues that much modern policy and many practices amongst investors were influenced by the two “false theories” of rational expectations and efficient markets, which

[…] are not only misleading but highly ideological, have become so dominant in academia (especially business schools), government and markets themselves. While neither theory was totally dominant in mainstream economics departments, both were found in every major textbook, and both were important parts of the “neo-Keynesian” orthodoxy, which was the end-result of the shake-out that followed Milton Friedman’s attempt to overthrow Keynes. The result is that these two theories have more power than even their adherents realise: yes, they underpin the thinking of the wilder fringes of the Chicago school, but also, more subtly, they underpin the analysis of sensible economists like Paul Samuelson.

[…]

As David Hendry, until recently head of the Oxford economics department, has noted: “Economists critical of the rational expectations based approach have had great difficulty even publishing such views, or maintaining research funding. For example, recent attempts to get ESRC funding for a project to test the flaws in rational expectations based models was rejected. I believe some of British policy failures have been due to the Bank accepting the implications [of REH models] and hence taking about a year too long to react to the credit crisis.”

[…]

Although there was never any empirical evidence for REH, the theory took academic economics by storm for two reasons. First, the assumptions of clearly-defined laws and identical expectations were easily translated into simple mathematical models—and this mathematical tractability soon came to be viewed as a more important academic objective than correspondence to reality or predictive power. Models based on rational expectations, insofar as they could be checked against reality, usually failed statistical tests. But this was not a deterrent to the economics profession. In other words, if the theory doesn’t fit the facts, ignore the facts. How could the world have allowed such crassly unscientific attitudes to dominate a serious academic discipline, especially one as important to society as economics?

The article also claims that this was desirable for ideological reasons:

That government activism was doomed to failure was exactly what politicians, central bankers and business leaders of the Thatcher and Reagan periods wanted to hear. Thus it quickly became established as the official doctrine of the political and economic establishments in America—and from this powerful position it was able to conquer the entire academic world.

And for efficient markets:

To make matters worse, rational expectations gradually merged with the related theory of “efficient” financial markets. This was gaining ground in the 1970s for similar reasons—an attractive combination of mathematical and ideological tractability. This was the efficient market hypothesis (EMH), developed by another group of Chicago-influenced academics, all of whom received Nobel prizes just as their theories came apart at the seams. EMH, like rational expectations, assumed that there was a well-defined model of economic behaviour and that rational investors would all follow it; but it added another step. In the strong version of the theory, financial markets, because they were populated by a multitude of rational and competitive players, would always set prices that reflected all available information in the most accurate possible way. Because the market price would always reflect more perfect knowledge than was available to any one individual, no investor could “beat the market”—still less could a regulator ever hope to improve on market signals by substituting his own judgement. But if prices perfectly reflected all information, why did these prices constantly fluctuate and what did such movements mean? EMH cut this Gordian knot with a simple assumption: market movements are meaningless random fluctuations, equivalent to tossing a coin or a drunken sailor’s “random walk.” This anarchic-sounding view was actually very reassuring. If market movements were really like coin-tosses, they might be totally irregular in the short term, but very predictable over longer periods, like the takings of a casino. Specifically, the coin-tossing and random walk analogies could be shown to imply what statisticians call a “normal” or Gaussian probability distribution. And the mathematics of Gaussian distributions (plus what is called the “law of large numbers”) reveals that catastrophic disturbances are vanishingly unlikely to occur. For example, if the daily fluctuations on Wall Street follow a normal distribution, it is possible to “prove” that the odds of a one-day movement greater than 25 per cent are about one in three trillion. The fact that at least four statistically “impossible” financial events occurred in just 20 years—in stock markets in 1987, bonds in 1994, currencies in 1998 and credit markets in 2008—would by normal standards, have meant the end of EMH. But as in the case of rational expectations, the facts were rejected while the theory continued to reign supreme, albeit with some recalibration.

Friday, March 6, 2009

That’s the claim in a brief, new and quite well-written paper called “The financial crisis and the systemic failure of academic economics”. The paper is written by a bunch of authors from US, Germany, France and Denmark, and claims that the profession was blind to the build-up of the financial crisis and underestimated its dimensions when it started to unfold. It argues that this failure can be traced “to the profession’s insistence on constructing models that, by desing, disregard the key elements driving outcomes in real-world markets.”

The authors take as a starting point that economists have a social function, an important part of which is to explain social phenomena such “unemployment, boom and bust cycles, and financial crisis”. Because of this, economists have an ethical responsibility to communicate when and where their models are applicable, and even to speak out if there is widespread abuse of them by others. This, the authors claim, is a responsibility economists have failed in.

They argue that financial models used for pricing derivatives and other instruments had to be based on short data series and shaky theoretical assujmptions, were used so widely or by market players so dominant that the individualistic “this is how you as a small and isolated market agent should value these assets” perspective was invalid, and provided a control illusion to users through their seemingly precise and quantitative relationships.

As for modern macro models, the authors argue that these are deeply flawed for a number of reasons:

Expectations are rational, which is taken to mean model consistent. Agents in the model are taken to understand how the model they exist in works. This means that expectation mechanisms are only validated internally (by comparing the assumptions to the other assumptions in the model) rather than externally (by comparing the assumptions with data or what is known about expectations and judgments under uncertainty from psychology or other disciplines). “A behavioral interpretation of rational expectations would imply that individuals and the economist have a complete understanding of the economic mechanisms governing the world.”

Representative agents. Each function (worker, consumer, invester etc.) in the economy is represented by one individual. This disregards the aggregation problem (how individual actions to achieve X may produce different outcomes in the aggregate from X. Like if everyone seated in an auditorium stands up to see better – each one assuming that the others will remain seated if they get up), and it reduces macro phenomena to micro phenomena. There are no differences in expectations or preferences between individuals, and there are no interaction mechanisms that allow emergent properties, where unintended and unforeseen consequences follow from the different individuals and the way they interact.

Empirically, the models are calibrated – and parameter estimates of discount functions etc. are taken from micro studies and placed in the utility function of the representative agent – again skipping the entire aggregation and interaction problem.

The authors argue that we should develop flexible, data-driven models for the macroeconomic phenomena we are interested in – and use these as benchmarks against which to test proposed theoretical models.

Finally, they also argue that theoretical results without established empirical applicability are used to support questionable policy claims. Walrasian general equilibrium theory and the finding of Arrow-Debreu that all uncertainty can be eliminated given sufficient contingent claims in the market are seen as underlying

the belief shared by many economists that the introduction of new classes of derivatives can only be welfare increasing […]. It is worth emphasizing that this view is not an empirically grounded belief but an opinion derived from a benchmark model that is much too abstract to be confronted with data.

Again, as in so much criticism against economics, the “as-if” argument is not tackled directly. This will make it easy to avoid the criticism without dealing with it by saying that the theories in question are not meant to explain anything they can be shown not to explain (even if that should be claimed or implied in the theoretical works in question), that they were abused by stupid and greedy people, that the cutting edge of research (as opposed to what everyone learns and takes away from the subject) has already done some even more sophisticated and complicated shit that is really good and solves all our problems, that interaction is fully handled now because somebody put two consumers rather than one into a recent theory, etc. etc.

Monday, March 2, 2009

When your theory fails to explain what you set out to explain there are two strategies often followed: One seems to be driven by an interest in the real world phenomena, which makes people open to altering even basic assumptions if these are important causal factors in the theory but lack empirical support. The other seems to be driven by an interest in theoretical “purity”, which makes people open to creating more and more absurd theories if that is what they need to retain and defend the core assumptions that define the "discipline” in their own eyes.

This is my take on the issue Krugman discusses in today’s column in the NY Times. He writes about how modern macroeconomics has fallen into an ivory tower decadence that makes our profession fail in its role as informed and thoughtful policy advisers. Writing on how business cycles are more persistent than Lucas and the Real Business Cycle people would expect, he claims that the profession divided:

One group went down the “new Keynesian” route, arguing that something such as small costs of changing prices must explain the rigidity we actually seem to see. This group isn’t averse to putting a lot of rationality into its models, but it’s willing to accept aspects of the world that seem clear in the data, even if it can’t (yet?) be fully explained in terms of deep foundations.

The other group decided that since they couldn’t come up with a rigorous microfoundation for price stickiness, there must not be any price stickiness: recessions are the result of adverse technological shocks, not demand shocks.

And the latter group, the equilibrium macro side, was so convinced of the logical correctness of its position that schools dominated by that view stopped teaching demand-side economics.

The really nice thing about Krugman’s column is that he brings up the important point that this matters because we are dealing with real world problems.

And the sad thing is that all of this matters. Our ability as a nation to respond to the current economic crisis is being seriously hampered by the gratuitous ignorance of many of our economists.

Sunday, March 1, 2009

Nassim “Black Swan” Taleb and Pablo Triana (a derivatives consultant) wrote an opinion piece in the Financial Times last year where they asserted that the risk management techniques taught by financial economists were to blame for hiding the true risks in the economy and allowing the economy to swell up to the bursting point. The opinion piece makes two interesting claims:

1. Many members of the economics profession saw the flaws in these methods but allowed the financial economists to keep their prestige (e.g. “Nobel” prize in economics) and spread their financial models to students. Those economists are bystanders who failed in their moral duty to stop this before it created our current woes

2. We will not convince financial economists of their errors through logical persuasion and data – we need to use shame/social pressure

So how can we displace a fraud? Not by preaching nor by rational argument (believe us, we tried). Not by evidence. Risk methods that failed dramatically in the real world continue to be taught to students in business schools, where professors never lose tenure for the misapplications of those methods. As we are writing these lines, close to 100,000 MBAs are still learning portfolio theory – it is uniformly on the programme for next semester. An airline company would ground the aircraft and investigate after the crash – universities would put more aircraft in the skies, crash after crash. The fraud can be displaced only by shaming people, by boycotting the orthodox financial economics establishment and the institutions that allowed this to happen.